How to Play This Buying Opportunity

The 10-day, equity-only, buy-to-open put/call volume ratio has just rolled over from a multi-year high

The 10-day, equity-only, buy-to-open put/call volume ratio has just rolled over from a multi-year high

"Last week, we also discussed the SPY's 36-month (three-year) moving average, currently situated around the 190 strike. As we move into this week's trading following an advance from the 2014-2015 lows, we are at an important juncture … A monthly close above this trendline would likely indicate that we are only in the throes of another correction, with a potential run to previous highs a strong possibility in the months ahead. But a close significantly below this moving average would likely indicate increasing risk that the 2014-2015 lows will be taken out."
--Monday Morning Outlook, January 25, 2016

After a Fed meeting last week and the release of fourth-quarter gross domestic product (GDP) numbers that met lowered expectations on Friday, the broad market rallied on the heels of a weak start. More importantly, the SPDR S&P 500 ETF Trust (SPY - 193.72) closed January above its 36-month (three-year) moving average, which we viewed as a potential technical marker that the worst is over, at least for the time being.

The SPY's January price action is similar to both August 2011 and August 2015, which we have referenced before. In August 2011, the SPY violated the key 36-month moving average intra-month, but a close above it at month's end preceded a strong rally that eventually took out old highs. This low occurred as panicky investors sold stocks after a credit-rating agency downgraded U.S. debt. Now, investors are assessing many risk factors, including the impact of lower energy prices, a slowdown in China, and what the Fed's next move will be in the midst of decelerating economic growth.

Price action is like August 2015 due to the extreme sell-offs that -- as we suggested in both instances -- may have been exaggerated by options expiration, with big put strikes below the market on index and exchange-traded fund (ETF) options acting as magnets, sparking "delta-hedge" selling. These sell-offs sparked panic, as traders pushed the SPY below support. But, as we discussed in last week's Monday Morning Outlook entitled "Was That Another Big Bear Trap?", last month's move below the 2015 lows is appearing to be a bear trap. Similarly, in August 2015, a push below the January 2015 low proved to be a bear trap, as a V-rally quickly followed the perceived technical breakdown.

Monthly chart of SPY since January 2006 with 36-month (three-year) moving averageA monthly hold above this long-term trendline is encouraging for bulls

"…short-term bulls should also be encouraged by the CBOE Volatility Index's (VIX - 22.34) plunge late last week. Internally, our thought was to focus on a move below the 25.60-27.30 area for a green light to bet on a tradeable bounce higher. This area marks double the fourth-quarter 2015 lows and half the 2015 high of 53.29.

"…if you are looking for more evidence of a VIX January peak being in place, look for February VIX futures to decline below the 23-24 area, site of heavy call open interest. The bet would be that unlike January expiration, when only 57% of VIX calls expired worthless, a much larger percentage of VIX calls will expire worthless on the morning of Feb. 17 expiration."
--Monday Morning Outlook, January 25, 2016

With the Federal Open Market Committee (FOMC) meeting behind us, and stocks rallying after the meeting, it is likely no surprise the volatility moved lower. The CBOE Volatility Index (VIX - 20.20) is now well below the 25.60-27.30 area that we viewed as important last week. In fact, the highs of the week were in this area, immediately following an initial negative reaction to the Fed's press release. The VIX took out another level we were keying on -- 23.90 -- which is double the 2015 low. Finally, February VIX futures closed below the 23-24 area, which is the site of heavy call open interest in the February series, which expire on Feb. 17.

With these volatility measures below key points that we identified last week, it appears VIX futures players classified by the Commitments of Traders (COT) report as "large speculators" are in danger of being wrong at a key turning point again, after moving into a net long position last week. Per the chart below, it is extremely rare for these speculators to be net long. Historically, volatility measures have plummeted soon after they took such a stance.

When large speculators in VIX futures market are net long, volatility has historically plummeted

With the technical backdrop improving after the mid-January plunge, bulls should welcome what we are seeing with respect to sentiment among equity-only option buyers. As you can see in the chart immediately below, the 10-day, equity-only, buy-to-open put/call volume ratio almost reached the multi-year highs of September/October 2015. A tremendous buying opportunity occurred when this ratio rolled over from those highs, and a similar rollover occurred again just last week. This is a sign that the panic selling of mid-January is over, signaling a change in sentiment from extreme fear that could be supportive of stocks in the weeks ahead.

Is the extreme in fear among equity option buyers (red line) marking another buying opportunity?

Another sentiment indicator that bulls should welcome is the weekly National Association of Active Investment Managers (NAAIM) survey, which attempts to quantify the equity allocation among investment managers surveyed. After reducing allocations since early December from mid-range levels, it appears this group is shopping equities at present -- but remain relatively underweight. Per the chart below, attractive buying opportunities have historically occurred when this group begins increasing allocations from low levels, which appears to be the case now.

The bottom line is that short-term negative sentiment appears to have run its course, and with multiple indexes holding at longer-term support -- recovering from an apparent sell-off exaggerated by January expiration -- equity markets should advance in the coming weeks.

SPY and/or PowerShares QQQ Trust (QQQ - 104.13) call options are one way to play a rally on mild pullbacks, as options allow you to reduce your capital outlay amid the various risk factors overhanging equities. However, all bets are off if the QQQ falls below $100 or if the SPY moves below $189.

If you have an investor mindset, continue to concentrate your holdings in larger-cap names, and avoid small-cap stocks. The Russell 2000 Index (RUT - 1,035.38) -- a small-cap benchmark -- continues to hold the 1,000 millennium mark, but remains lower by close to 10% year-to-date, while the SPY is off only about half as much.